June 2024: A Sense of "Unsecurity"

These days, how should one think about unsecured consumer lending? In this month’s edition of The LoanStreet Beat, we feature a deep dive into how some seasoned unsecured loan pools have been performing and compare that performance to expectations. In addition, we recap an active economic news cycle and share our observations on loan trading. 

As a reminder, our webinar, “Next-Gen Analytics: Inform your liquidity management and capital allocation,” is on Wednesday, June 12. Register here.

LoanStreet Market Commentary

May’s economic data started to paint a clearer picture of what is going on in the economy - Inflation is cooling, albeit at a slow pace, while the consumer is spending less as the job market tightens. The April job numbers delivered the perfect balance of robust yet slowing employment growth. The headline jobs number was 175k, which was well below the estimated 240k. In any other year, creating above 100k jobs would have been a strong report, but not in a year when we regularly saw 300k+ jobs being added in any given month. Along with the relatively weak jobs number, the unemployment rate edged higher to 3.9% from 3.8%.

The inflation reports, both CPI and PCE, came in on the soft side. The headline CPI inflation number came in at +0.3%, compared to the estimated +0.4%, and the core CPI came in as expected at +0.3% as compared to +0.4% back in April, the first deceleration in core CPI in six months. Shelter, which is the driving force of the index with its ~36% weight, rose +0.4% MOM and +5.5% YOY, making it the key culprit in why inflation continues to remain above its 2% target. In addition to shelter, motor vehicle insurance, with its 2.9% index weighting, also contributed to the stubborn inflation as it increased 1.8% MOM. The PCE delivered similarly good news, as both the headline and the core numbers came in as expected, with a +0.3% and +0.2% increase month-over-month, respectively.

While the inflation side of the equation seems to be heading in the right direction, there are some concerns around growth. Retail sales numbers came in unchanged MOM for April, well below expectations of a +0.4% increase. Seemingly the consumer is feeling the impact of higher rates, but they appear to be trying to maintain their spending habits by depleting savings. Similarly, the recently-released manufacturing ISM report came in at 48.7 vs the estimated 49.5. One of the key factors driving down the index was new orders, which came down 3.7%, signaling a slowdown in demand from downstream buyers. The good news was that prices paid came down 3.9%, signaling input costs are cooling.

This creates a tricky scenario for the Fed as inflation is largely driven by factors they can’t control - shelter and insurance costs - while at the same time, the consumer is showing signs of weakness. This is part of the reason why expert opinions vary; those focused on inflation are calling for “higher-for-longer” while others are calling for immediate rate cuts due to the risk of hurting the economy.

Loan Trading Trends and Implications

The LoanStreet platform continues to see strong volumes as the market remains balanced between buyers and sellers. The most in-demand product remains auto, but as spreads tighten on auto pools, buyers are turning to other asset classes to find more attractive execution. The latest report from Experian automotive finance report shows that credit unions continue to lose market share in the auto space. For new autos, captives have a 61.8% market share, the highest since 2010. For used autos, credit unions' market share is returning to historic norms after the recent peak. Further, due to the competition from captives and improvement in the supply chain, new autos are taking share away from used auto as the percentage of new auto has increased from ~38% in 2023 to ~42% in 2024. Since used auto is a large portion of a typical credit union’s balance sheet, their auto origination volume is taking a hit. As a result, auto participations remain in demand. With data signaling a slowdown in spending, loan volumes are likely to remain at below-plan levels. 

To maximize execution, sellers should be prepared to provide clean static loss data to the buyers. With a general softening of the economy, performance is top of the mind for many potential buyers. At the same time, as participation demand continues to increase, buyers need to reevaluate their yield hurdles and their buy-box. In today’s market, buyers have lost the leverage they held in 2023 and face tougher competition when it comes to finding a participation pool to purchase.

Deep Dive: A Sense of Unsecurity - Unsecured Loan Performance

While a relatively small portion of most credit union’s loan portfolios, unsecured loans have generated a disproportionate amount of concern of late as delinquencies and loss rates increase. However, as we discuss in our white paper “What To Expect When You’re Expecting”, losses should be expected to rise as loans age, or “season,” with low/no losses in early months (and the associated outperformance) and with higher losses in later months (and a reduction in the early outperformance). This occurs for several reasons, the two most notable being that 1) a newly underwritten loan is unlikely to run into difficulties making payments immediately, and 2) it takes time to work through the loss recognition process, so even if a loan defaults immediately, it can take several months before the loss on that default occurs. 

So how have loans been performing?

To try and answer this question, we looked at a handful of pools sold on our platform during our busiest loan participation quarters - 2020Q3, 2020Q4, and 2021Q1—selecting four of the larger pools sold during that time from one originator: PEA-C49, PEB-2A4, P78-B41 and P9D-6C3. We then compared the performance to-date to what was expected based on the projections provided at that time by the originator, adjusting each pool’s projection for its individual characteristics.

In our data room, the provided cumulative loss timing curves for 36- and 60-month loans were further broken down into Prime and Prime Plus segments for 36-month loans (though 60-month loans have Prime and Prime Plus designations, the originator did not differentiate their performance). Stratifying each pool by those criteria enables us to combine the various curves into a loss estimate for each pool, both in terms of timing as well as a cumulative loss. The following table shows the breakdown for each of the four pools, the originator’s loss forecast for each segment, and the cumulative expectation for each pool.

Now we need just compare these figures to actual performance. As none of the pools are fully seasoned and therefore through their lifecycle, instead of comparing the actual cumulative losses[1] to the terminal expectation, we instead look at the loss-timing curves.

As can be seen, in all cases, the actual losses have come in lower than expectations. However, looking more closely, the outperformance as seen in the spread between the two lines on each graph, increases in the early months, eventually peaking at around two years of seasoning, and then shrinks, though still remaining below expectations. This means that realized losses were more back-end loaded than expected, and, given that pool balances are generally smaller at that point, would result in high annual loss figures, giving the perception of underperformance when looking at short-term metrics like annual loss rate.

The back-end shift in the loss timing could have many causes, including a change in the economic environment. This could mean that newer pools that experience more of their life cycle in the new economic environment would be performing worse than these examples. However, for pools that were issued at the peak of the available supply, the longer view indicates that these pools have, to date, outperformed from a loss perspective.

[1] LoanStreet’s analytics report net losses while the originator’s projections are gross charge-offs, however, given the relatively low loss recoveries on unsecured, this should not materially affect the results.

Monthly Economic Data Summary

• Based on the 5/31/2024 report, the PCE gauge of inflation increased by 0.3% MOM and 2.7% YOY. This was in line with expectations.
• From the same report, core PCE, which excludes food and energy, rose 0.2% MOM and 2.8% YOY. This was in line with expectations.
• On 5/15/2024, we received the latest CPI gauge of inflation. The MOM increase of 0.3% was below the projected 0.4%, and the YOY increase of 3.4% was in line with expectations.
• The April jobs report, released on 5/3/2024, showed 175,000 jobs created, compared to the 240,000 estimate.
• The latest used-vehicle Manheim Market Report for mid-May showed a slight increase in prices of 0.3% MOM, but down -11.3% YOY, on an adjusted basis.
• The Case-Shiller home price index showed national home prices increasing MOM by 1.3% while increasing YOY by 6.5%. These are lagging data and reflect the CS indices for 03/24.
• Based on the CME market watch tool, the expectations of the first rate cut has been brought forward from November to September 2024 when compared to last month.

This article was authored by Eric Marcus, Managing Director and Head of Trading, and Matt Rudzinski, Director of Sales and Trading.

For more market commentary and to learn more about LoanStreet's solutions, visit www.loan-street.com

Disclaimer

LoanStreet is not a Registered Exchange, Financial Planner, Investment Adviser, or Tax Adviser. The information provided herein is for general informational purposes only, and does not, and is not intended to, constitute legal, financial, investment, or tax advice.